Economics 401 – Answers to Problems from Chapter 7 Show Review Questions 2. (a) Real money demand is $50,000 – $500,000(i – im) = $20,000 What happens when the money supply increases?An increase in the supply of money typically lowers interest rates, which in turn, generates more investment and puts more money in the hands of consumers, thereby stimulating spending. Businesses respond by ordering more raw materials and increasing production.
What happens to money supply when interest rates fall?Lower rates increase the money supply and boost economic activity; however, decreases in interest rates fuel inflation, and so the Fed must be careful not to lower interest rates too much for too long.
Why does interest rate fall when money supply increases?More money in the economy means more liquidity with the people. When People are having adequate money they will borrow less. When there is no demand for loans, Banks reduce the rate of interest on loans so that they can attract people to borrow. Demand supply theory can be used here also.
What happens to the interest rate if the money supply increases or decreases and the money demand remains unchanged?Assuming that money demand remains constant, increase in money supply raises interest rates thereby increasing the opportunity cost of holding cash as well as stocks.
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